Investors Wake Up To The Perils Of Higher Interest Rates



There’s An Old Saying On Wall Street: “The Trend Is Your Friend”


Meaning if the market is moving a certain way you shouldn’t try to fight it. See warning signs? You can probably ignore them for a while, until you absolutely can’t. We may be at that “can’t ignore the warning signs” moment right now.

Or maybe not. One sharp one day plunge does not make a bear market. In terms of both points and percentage the 800 point plus dive for the Dow wasn’t even as bad as the scary single-day drop of more than 1,000 back in February, from which the market quickly recovered, and then hit new highs.  And most stocks are still up from where they were at the beginning of the year. Also, the President’s not lying when he says economic growth is strong and steady and unemployment is really low. And even though interest rates have been steadily creeping up, they’re still pretty low by historical standards. While the International Monetary Fund this week cut its forecast of global economic growth for next year to 3.7% from 3.9%, that still matches the strongest year this decade.

On the other hand, the IMF citing conflicts between the U.S. and China along with bigger than expected increases in global interest rates as major concerns. And IMF Chief Christine Lagarde, says stock valuations have been “extremely high”.

Today, markets in Asia and Europe so far continued in what’s become a steep global sell off.

So why did the threat of higher interest rates and inflation suddenly come sharply into focus? And why did the trade war with China, which many on Wall Street had been treating as a bluff, suddenly become seen as dead serious?

Tariffs Are Inflationary. Trump argues that if you’re going to do a trade war, this is the best possible time to do it: the U.S. economy is booming and so it should be able to absorb a few blows here and there. And he’s right about that. But it has to be carefully managed by a steady hand. Because tariffs make Americans pay more for many of the goods they want. (Or they can decide not to buy them at all.) Earlier this month we warned you that Wall Street was making a dangerous presumption that Trump’s trade war bluster was a bluff; just using it to get other countries to the table. And that doesn’t seem to be the case with China, at least not right now, where Trump has turned up the heat once with a vast expansion of tariffs, and threatens to do it again. So while the President is putting pressure on companies in China by hurting their ability to sell into the U.S., it’s American companies and consumers that are paying those extra tariffs, forcing them to borrow more and at higher rates in order to be able to afford those now higher-priced goods.

In addition, the U.S. made an unbelievably bold move this week that cannot possibly do anything but intensify conflict with China. And started to make good on strong threats from Vice President Mike Pence we reported on last week. The F.B.I. lured a Chinese national suspected of trying to steal secrets from a U.S. aerospace company to Belgium, arrested him and extradited him to the U.S. to face charges. Xu Yanjun is currently in jail in Cincinnati. This story has not been that widely covered yet. It will be.

The U.S. Government May Need To Borrow A Lot More Money Than It Said. Even though the economy is booming, tax revenues are coming in to the federal government at near Recession levels. The Congressional Budget Office says the federal budget deficit in the fiscal year just ended rose more than 17% to $782-billion. A lot of the shortfall due to the $1.5-trillion dollar tax cut Trump and Republicans gave out, with the lion’s share going to corporations. In fact, corporate income tax receipts fell 31%. That tax cut was supposed to “pay for itself”. It’s not.

What does this have to do with interest rates? The U.S. government is already the biggest borrower in the world. (Yes, Trump is now more than rhetorically the “King of Debt”.) With tax revenues dropping, it’ll need to borrow even more to cover the rising national debt. But it’ll need to pay more to borrow that money in the form of higher rates. Which means we’ll all need to pay higher rates to borrow money too, since we’re all considered higher risk than the federal government.

The President’s Relationship With The Federal Reserve Is Also Crucial. The Fed’s number one job in good economic times is to prevent inflation by making sure the economy doesn’t overheat. That’s no small feat when the U.S. is doing its biggest economic stimulus at a time the economy is already booming, in the form of that massive tax cut. (In fact, the $1.5-trillion package is almost double Obama’s 2009 economic stimulus plan. And that was done during a Recession). That puts a lot of dollars out into the economy competing for the same pool of goods (which may be a smaller pool if tariffs are keeping some products out). And that too can lead to higher interest rates and inflation. If people with lots of dollars are competing to buy things, it makes everything cost more. To head that off, the Fed has been raising rates slowly and little by little, kind of like trying to inoculate the economy against even a remote possibility of an out-of-control disease. It’s a very boring and routine kind of thing for the Fed to do.

Trump hates it. And while the President has taken all the credit for the stock market’s gains, he’s made it very clear that if there’s a sustained downturn he’s taking no responsibility for any of it. Instead, he plans to scapegoat the Fed. Here’s a clip from CNBC where he says the Federal Reserve has “gone crazy”:


Later, more colorfully, the President changed that to “going loco”.

Portfolio managers spun the day’s events as nothing to get too terribly worried about. But they lose money if people get out of their stocks. One such manager telling CNBC:

“In February, everything got shellacked. Even banks didn’t get hit that bad today. It wasn’t what you’d expect in a full-blown washout sell-out. To me, that was the most important piece, that this is not going to herald something worse.”

Only we’re not sure we buy that. We think more targeted selling may be signalling exactly the opposite: that this is not the to-be-expected broad market sell-off we see every once in a while, but a more unusual event: